Unit 3 Political economics key points to prepare

Question 1

What is monetary policy?

Answer 1

Monetary policy consists in managing the quantity and price of money to achieve one or several objectives depending on the central bank’s mandate:
- Price stability
- Full employment
- Exchange rate stability

Question 2

Monetary policy as stabilisation policy

Answer 2

by affecting interest rates, it alters households’ and firms’ intertemporal decisions

Question 3

How does monetary policy differentiate from fiscal policy?

Answer 3

1. Monetary policy is generally delegated to an independent agency - the central bank - with an explicit and narrow mandate, generally price stability.
2. Monetary policy affects aggregate demand only indirectly whereas fiscal authorities purchase goods and services directly

Question 4

How is monetary policy used?

Answer 4

If there is a danger of recession, interest rates are often cut
- Expansionary monetary policy: the use of monetary policy tools to increase the money supply, lower interest rates and stimulate a higher level of economic activity
- Sometimes such an expansionary monetary policy is called an accommodating monetary policy especially (though not exclusively) when the central bank is reacting to a specific economic event that might otherwise tend to send the economy into recession,
-Contractionary monetary policy: the use of monetary policy tools to limit the money supply, raise interest rates and encourage a levelling off or reduction in economic activity

Question 5

What do the central banks do? - Monetary policy

Answer 5

The central banks define and implement monetary policy
- They issue banknotes and coins
- They extend liquidity to banks via open-market operations
- They impose compulsory reserves on commercial banks
- On a temporary basis they act as lenders of last resort to banks

Banking supervision (not all) and contribute to the stability of the financial system

In some cases they can finance governments

Question 6

Agents of monetary policy

Answer 6

Monetary policy is designed and implemented by central banks. May have private shareholders but operate under a public mandate written in law or constitution

Question 7

Stabilisation, but also allocation and distribution- Monetary policy

Answer 7

Although its purpose is macroeconomic stabilisation monetary policy also has allocative and distributive consequences
- At a given point in time, a lower interest rate reduces the income of savers and benefits debtors
- Central bankers consider such distributive consequences limited and balanced over the business cycle, and they see them as means to an end
-Politicians and citizens sometimes disagree, which may lead them to challenge the central bank’s mandate
- Controversies have become more frequent since the global financial crisis, as the scope and magnitude of central intervention have increased

Question 8

Objectives of monetary policy

Answer 8

• The objective that central banks should pursue are specified in their mandate
• These have varied significantly over time and are still a matter for discussion among politicians and economists
• In the 1970’s, it was common for central banks to have broad mandates involving difficult trade-offs between alternative targets
• One of the lessons drawn from the high inflation of the 1970s and the 1980s has been that central banks ought to be given more precise objectives -> price stability emerged as the dominant one
• However, not all central banks have a mandate focused on price stability, and even those that do may have to pursue other objectives simultaneously

Question 9

Price stability - primary objective of monetary policy

Answer 9

• Pursuing price stability amounts to safeguarding the real value of money; that is, its purchasing power defined as the quantity of goods, services or assets that one unit of money can buy. More precisely, it amounts to maintaining its internal value (its purchasing power in terms of the domestic consumption basket), which may be different from its external value (the purchasing power in terms of foreign currencies).
• Most central banks aim at keeping the inflation rate at a low value
• The monetarist view implies that price stability only requires controlling the amount of money in circulation and makes monetary policy the natural instrument for controlling inflation

Question 10

Three reasons why price stability should be central banks’ primary mandate:

Answer 10

• Price stability is a desirable objective from a social welfare perspective
• Central banks are best placed to achieve it
• and assigning any other task to them would distract them from accomplishing the former

Question 11

Other justifications for assigning the control of inflation to the central bank

Answer 11

• Economic argument: contemporary economic models retain an important assumption called the long-term neutrality of money -> the disconnection, in the long run, between nominal variables (such as the general level of prices, nominal wages, interest rates, the nominal exchange rate etc) and real variables (real GDP, employment, real wages, real interest rates etc). Hence, entrusting the central bank with a narrow mandate of price stability comes at no cost in the long term.
• Institutional arguments: While potential institutions face trade-offs with other objectives, an independent agency with a narrow mandate is better equipped to achieve it and more credible to communicate its actions to economic players. In addition, monetary policy is highly technical, and its success can only be assessed over a long period.

Question 12

Output stability

Answer 12

• The strong focus of central banks on price stability does not exclude output stabilisation
• As a matter of fact, even when output stabilisation is not they main objective, central banks behave in practice as if they were aiming at minimising the output gap on the top of achieving their inflation objective

Question 13

Taylor Rule - Output stability equation

Answer 13

rt= r* + πt + α(πt-π) + β(yt-yt)/yt
where rt is the short-term nominal interest rate, πt the inflation rate,
π the inflation objective, (yt − yt)/yt the output gap, and r* the
“neutral” level of the real interest rate, and and alpha and β are the
policy parameters.

Question 14

Taylor rule - output stability

Answer 14

Taylor rule has become one of economists’ basic tools to assess policy interest rates.
- Although it has no normative content, the Taylor rule is a useful standard for comparing monetary stances over time and across countries -> the natural rate of interest allows us to assess whether a given real interest rate is accommodative or restrictive

Question 15

Long-term neutrality of money

Answer 15

• Changes in money supply do not affect real economic variables in the long run, a property known as the long term neutrality of money
• Only nominal variables (nominal GDP, nominal wages etc) are affected
• Hume’s quantity theory of money states that output is determined by supply and that the value of the transactions that can be carried out with one unit of money during a given period - the velocity of money - is exogenous
• ## Controlling money growth allows the central bank to control the inflation rate without incurring any cost in terms of real variables such as real GDP or unemployment

Question 16

Quantity Theory of Money - equation

Answer 16

Money velocity V is defined as the nominal production allowed by the circulation of one unit of money during one year:
PY = MV
P = general price level
M = money supply
Y = real GDP
V = money velocity.
Assume that V is constant of evolves at a constant rate independently of monetary policy. If the central bank controls the growth rate of money supply ΔM/,M then, for a given GDP growth rate ΔY/ Y and a given evolution of velocity ΔV/ V, it also controls inflation ΔP/ P.
ΔP/ P = ΔV/ V + ΔM/,M - ΔY/ Y

Question 17

The quantity theory of money

Answer 17

• the link between money growth and inflation raises little discussion.
• However, the long-run neutrality of money does not imply that monetary policy has no influence whatsoever on real economic performance
• It may affect GDP in the short term due to nominal rigidities or high leverage of economic agents-> in the long run, high and unstable inflation is widely accepted as having detrimental effects on growth

Question 18

Transmission channels of monetary policy

Answer 18

Four transmission channels of monetary policy are usually distinguished
- The interest-rate channel
- Asset-price channel
- Credit channel
- External channel
All four operate in parallel and contribute to the general equilibrium outcome

Question 19

The interest rate channel

Answer 19

The interest rate channel is the traditional Keynesian channel: in the presence of nominal rigidities, a monetary expansion leads to a fall in the (nominal and real) interest rate, hence this attracts investment and and the aggregate demand of durable goods consumption increases

Conventional policy: This is when the central bank changes the overnight interest rate. It’s a quick and direct way to control the economy’s speed.

Non-Conventional Measures: These are other ways the central bank can influence how much money is in the economy, affecting longer-term interest rates. This can include things like buying government bonds or other financial actions

The impact of changing interest rates depends on several things:
- Communication strategy
- Relationship between short-term and long-term rates
- Banks passing on changes
- Fixed vs Variable rates

Question 20

The asset price channel

Answer 20

The asset price channel relies on the negative relationship between asset prices and interest rates: a decrease in the interest rate generally raises the value of financial assets held by households,
- The asset price channel also affects the corporate sector: a rise in stock prices increases the profitability of investment

Question 21

The credit channel

Answer 21

Credit is the money that banks lend to people and businesses. The credit channel is about how the interest rate (the cost to borrow money) affects how much money banks are willing to lend out. Therefore lower policy rates induce banks to higher risk profiles and stimulate credit supply (aggregate demand increases)
Asymmetric information means that banks do not have all the information about how risky a borrower’s project might be
Because banks cannot know everything about a borrower’s ability to pay back, they add a ‘risk premium’ to the interest rate. This is like adding extra cost to cover the chance that the borrower might not pay back. This agency cost dissuades good investment projects whose probability of failure is low.
The more the bank increases the interest rate, the more it actually discourages good projects and selects bad ones

Question 22

The external channel

Answer 22

When a country lowers its interest rates, its assets become less attractive compared to foreign ones, leading investors to prefer investing abroad, which can decrease the value of the country’s currency. Conversely, raising interest rates makes domestic assets more appealing, attracting more investment and potentially increasing the value of the country’s currency.

Question 23

Inflation targeting as a monetary strategy

Answer 23

Inflation targeting: The central bank picks a desired inflation rate - a rate at which prices of things increase - and aims to achieve this rate in the medium term.
Advantages:
- Transparent and predictable: Everyone knows what the central bank is aiming for
- Flexible and proactive: The central bank can react to sudden changes, like a sudden increase in oil prices, without losing sight of its main goal
- Balanced approach: it is like having a set of guidelines but also being able to use different types of information to make decisions, which is better than just following a strict rule no matter what.

This approach requires the central bank to be disciplined and sophisticated in how it manages things,
In some newer or developing economies, people might not fully trust the central bank or the way inflation is measured, which can make inflation targeting less effective

Question 24

The ECB’s monetary policy strategy - primary objective + two main elements

Answer 24

The primary objective of the ECB is to maintain price stability in the euro area.
These objectives include balanced economic growth, a highly competitive social market economy aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment.

The ECB’s monetary policy strategy comprises two main elements:
1. Economic analysis: A quantitative definition of price stability (short to medium term)
2. Monetary analysis: A two-pillar approach to the analysis of the risks to price stability
- Analysis of economic dynamics and shocks
- Analysis of monetary trends (medium to longer-term)

Question 25

ECB’s strategy review 2021

Answer 25

The 2021 ECB’s strategy review determined:
1. They confirmed that the Harmonised Index of Consumer prices (HICP) is still a good way to measure price changes. They also realised that including costs related to owning a home in this index would give a better picture o how inflation affects regular households.
2. The council aims to keep inflation at about 2% over the medium term. The two percent inflation target provides a clear anchor for inflation expectations, which is essential for maintaining price stability
3. The governing council confirms the medium-term orientation of its monetary policy. This allows for inevitable short-term deviations of inflation from the target.
4. The governing council will also employ forward guidance - which means they will let the public and businesses know about what they plan to do in the future
5. The governing council will continue to respond flexibly to new challenges as they arise and consider, as needed, new policy instruments in the pursuit of its price stability objective

Question 26

What does the ECB’s conventional instruments consist of?

Answer 26

1. Open market operations
2. Standing facilities
3. Minimum reserves

Question 27

Open market operations

Answer 27

Open market operations play an important role in the monetary policy of the Eurosystem for the purposed of steering interest rates, managing the liquidity situation in the market and signalling the stance of monetary polucy

Question 28

ECB’s official interest rates

Answer 28

The Governing Council of the ECB sets three rates:
1. The interest rate on the main refinancing operations: Commercial banks can borrow funds from the ECB against collateral at a pre-determined interest rate
2. The rate on the deposit facility: which banks may use to make overnight deposits at a pre-set rate lower than the main refinancing operations rate
3. The rate on the marginal lending facility: which offers overnight credit to banks at a pre-set interest rate above the main refinancing operations rate

Question 29

Open Market Operations (OMO) (5 instruments)

Answer 29

5 types of instruments are available to the Euro system for the conduct of open market operations:
1. Reverse transactions (applicable on the basis of repurchase agreements or collateralised loans)
2. Outright transactions (refers to operations where the Euro system buys or sells eligible assets outright on the market)
3. Issuance of ECB debt certificates
4. Foreign exchange swaps (executed for monetary policy purposes consist of simultaneous spot and forward transactions in euro against a foreign currency)
5. Collection of fixed-term deposits (accepted from counterparties for a fixed term and with a fixed rate of interest)

Question 30

Tender allotment procedures Fixed rate - Open Market Operations

Answer 30

In a fixed rate tender operation, banks submit bids to borrow money from a central bank at a predetermined interest rate. If the total amount bid by all banks surpasses the central bank’s available funds, the allocation of money to each bank is done on a pro rata basis. This means each bank receives a portion of the funds in proportion to its original bid relative to the total amount requested by all banks.

Question 31

Variable rate tender operations - tender allotment procedures - open market operations

Answer 31

• In the allotment of liquidity-providing variable rate tenders in euro, bids are listed in descending order of offered interest rates.
• In the allotment of liquidity-asboribing variable rate tenders (which may be used for the issuance of ECB debt certificates and the collection of fixed-term deposits), bids are listed in ascending order of offered interest rates

For variable rate tenders, the Euro system may apply either single rate or multiple rate auction procedures.
- In a single rate auction, the allotment interest rate applied for all satisfied bids is equal to the marginal interest rate
- In a multiple rate auction, the allotment interest rate is equal to the interest rate offered for each individual bid

Question 32

Categories of OMO according to aims, maturity, frequency and procedure

Answer 32

1. Main refinancing operations. Aim = reverse transactions (provision of liquidity), maturity is one week, frequency is weekly and procedure is standard tenders.
2. Longer-term refinancing operations. Aim = Reverse transactions (Provision of liquidity), maturity is three months, frequency is monthly and procedure is standard tenders.
3. Fine-tuning operations. Aim = reverse transactions, foreign exchange swaps (provision and absorption) and collection of fixed-term deposits. Maturity is non-standardised, frequency in non-regular and procedure is quick tenders and bilateral procedures.
4. Structural operations. Aim = Reverse transactions and outright purchases (provision) and issuance of ECB debt certificates and outright sales (absorption), maturity is blank, frequency is non-regular and procedure is bilateral procedures.

Question 33

Standing facilities

Answer 33

1. The marginal lending facility
   - Counterparties may use the marginal lending facility to obtain overnight liquidity from national central banks at a pre-specified interest rate against eligible assets.
   - The facility is intended to satisfy counterparties’ temporary liquidity needs. The interest rate for this emergency borrowing sets the highest limit for overnight loans in the market.
2. The deposit facility
   - Counterparties can use the deposit facility to make overnight deposits with national central banks. The central bank pays the bank a little bit of interest for this deposit and this rate is also fixed in advance. This rate usually acts as the lowest limit for interest rates in the overnight market.

Question 34

What is the liquidity trap?

Answer 34

A liquidity trap occurs when interest rates are very low and savings rates are high, making monetary policy ineffective. In this situation, people choose to hold onto cash instead of investing or spending, despite the availability of more money, leading to stagnant economic growth

Question 35

Unconventional measures of the ECB

Answer 35

1. Forward guidance: Providing ‘forward guidance’, where the central bank makes clear its intentions for future monetary policy
2. Qualitative easing: Changes in balance sheet composition of the central bank
3. Quantitative easing: Changes in balance sheet size of the central bank

Question 36

Forward guidance - Unconventional measures of the ECB

Answer 36

• Forward guidance consists in communicating about future monetary policy in order to guide market expectations
• It is a tool used by the central bank to provide indicators about its monetary policy intentions, including the expected future path of its key interest rates.
• Forward guidance is based on the ECB Governing Council’s assessment of the current economic situation and, in particular, inflation developments and outlook
• This tool allows the ECB to influence medium and long-term interest rates
• It allows consumers and businesses to make saving and investment decisions with more information on the future path of short-term interest rates

Question 37

Quantitative Easing - Unconventional measures of the ECB

Answer 37

Asset purchases, also known as quantitative easing consists in the purchase of financial assets on the secondary market by the central bank, in order to lower longer term interest rates.
In summary:
1. The European Central Bank buys bonds from banks
2. This increases the price of these bonds and creates money in the banking system
3. A wide range of (long-term) interest rates fall and loans become cheaper
4. Businesses and households are able to borrow more and spend less to repay their debts
5. Consumption and investment receive a boost
6. Higher consumption and more investment support economic growth and job creation, and help bring inflation to 2%

Question 38

Qualitative easing - Unconventional measures of the ECB

Answer 38

• Setting negative interest rates, which encourage banks to lend at low rates so that people and businesses can borrow cheaply
• Offering banks as many central loans as they need, against collateral at a fixed interest rate
• Offering long-term loans to banks, including loans at very favourable rates, on the condition that banks lend this money on to people and businesses